Commentary - Q4 2025

During the fourth quarter of 2025, the market, as represented by the S&P 500 Index, produced a return of 2.7%. For the full year, the Index generated a 17.9% return. The S&P 500 Growth Stock Index returned 2.2% for the quarter and 22.2% for the year. The S&P 500 Value Index produced a 3.2% return for the recent quarter and a 13.2% return for the year. Other sectors of the market produced favorable returns in the fourth quarter as well. The S&P SmallCap Index returned 1.7% for the quarter and 6.0% for the year. The S&P MidCap Index rose 1.6% in the last quarter and 7.5% for the year.

There were indications that investors remained optimistic as the year ended. The trailing twelve-month PER for the S&P 500 Index was about 31x at the end of 2025, well above the long-term median of about 17x. The VIX Index, a measure of anticipated volatility, stood at 14.5 at the end of the year, about the same level at which it began the year, but down from the yearly high of about 60. High valuations and low anticipated volatility are consistent with a positive outlook for stock market returns.

The capitalization-weighted S&P 500 Index was driven higher, in large part, on the strength of the performance of very few large capitalization growth stocks. The seven largest have been called “The Magnificent Seven” (Apple, Amazon, Alphabet, Meta Platforms, Microsoft, Nvidia, and Tesla), and they represent about 34.4% of the capitalization of the S&P 500 Index. The Seven have experienced much higher returns than the Index over the last ten years and as a result their weighting has increased from 12.3% of the Index at the end of 2015 to the current weighting. The ten-year trend continued in 2025 when the return for the Seven was 27.5%, above the 17.9% experienced by the Index. 

Among the largest stocks, Alphabet, the parent company of Google, generated a 65% return in 2025, the highest among the largest seven stocks. A measure of the impact of the very largest stocks on the performance of the Index is the difference between the returns for the capitalization- weighted Index and the equal-weighted version of the same Index, 17.9% versus 11.4%, respectively.

During the year, the Fed lowered the effective Fed Funds rate to 3.72% from 4.33%. While investors in the stock market seemed to hang on every word uttered by the Fed Chairman to see if they could discern some willingness on the part of the Fed to lower the Fed Funds rate further, there was little evidence bond market investors were concerned with the Fed’s behavior in the short-term. Bonds, as measured by the performance of the Bloomberg US Aggregate Index, returned 7.3% in the last year.

The shape of the yield curve at the end of the year revealed expectations for moderate to low inflation and moderate to low real economic growth in the near to medium term. Short-term rates for government obligations were about 3.6%, two-year obligations yielded about 3.6%, and the ten-year note yielded 4.2%. The yield on the ten-year obligation at the end of 2025 was virtually the same as it was at the end of 2024. The combination of a positively shaped yield curve and rates in the 3.5% to 4.2% range reflect expectations for real growth and inflation to fall in the range of 2% to 3% in the near term and for the foreseeable future.

An inventory of economic conditions supports the expectations revealed in the shape and location of the yield curve. Real GDP growth for all of 2025 and 2026 is expected to fall in a range of 2.0% to 2.5%. In the second half of 2025 real economic growth appears to have been much higher than it was in the first half. Inflation as measured by the CPI is running at about a 2.7% annual rate. This rate is above the Fed’s target of 2.0%, but well below rates experienced in the previous four years. Unemployment rose from 4.0% at the beginning of the year to 4.4% at the end of the year as job creation slowed down.

The slowdown in job creation has been attributed to the uncertain nature of economic policies. The whimsical nature of tariff policies is most often cited as a source of uncertainty, as are the opaque ruminations of the Fed, and the challenges facing the implementation of fiscal policies because of the large and growing budget deficit. Currently the rate of growth of the money supply is adequate to sustain economic growth in the 2.0% to 3.0% range without raising the rate of inflation, all other things being equal.

The Congressional Budget Office (CBO) estimates the budget deficit for the coming fiscal year will be about $1.9 trillion. Normally a deficit of this magnitude would be expected to stimulate a slowdown in spending or an increase in tax rates, but it seems Congress has no appetite to do either. The Trump Administration increased tax rates when it raised tariffs and Congress is unlikely to raise tax rates further in an election year. The path forward for tariffs is uncertain.

The consensus forecast for corporate profits in 2026 envisions a 12% to 15% increase. If this outcome is realized, the stock market will likely perform well in the year ahead, and the broad market indexes will reach new highs.

The stock market’s advance over the long term has been relentless. While there have been declines from time to time, over the last 45 years, since President Reagan’s first term, the market has generated an average annual return of 9.2% over the rate of inflation, and a nominal annual return of 12.3%. In the 15-year period prior to the beginning of the long bull market the return on stocks was roughly 1% below the rate of inflation, more than 10 percentage points below the bull market returns. The long bull market has taken place in an economic environment that included, on average, lowered tax rates, lowered regulations, and low to moderate inflation. During the 15 years of inferior performance the economic environment included rising inflation, rising regulations, and rising tax rates. If the good times are going to persist, the economic policies that were the foundation for those good times must persist.

Sources: S&P Dow Jones Indices, US Bureau of Labor Statistics, CBOE, Bureau of Economic Analysis

The information contained in this commentary represents the opinion of Affinity Investment Advisors, LLC and should not be construed as personalized or individualized investment advice. The analysis and opinions expressed in this report are subject to change without notice. The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. This report includes candid statements and observations of economic and market conditions; however, there is no guarantee that these statements, opinions, or forecasts will prove to be correct.